When is an assignee or judgment creditor taxed on partnership income?

Family limited partnerships (FLPs) have become part of the lexicon of tax planners, most commonly due to their transfer tax valuation advantages. However, FLPs have also been touted for their creditor-protection advantages. A judgment creditor must generally obtain a "charging order" from a court to give the creditor the right to any distributions that would otherwise be made to a limited partnership (LP) interest holder. A charging order is a court-ordered remedy that may also be obtained against a limited liability company (LLC) member. Some argue that the tax law serves as a buffer against an aggressive creditor, because, according to Rev. Rul. 77-137, with a charging order, the creditor will be taxed on all distributive-share income allocable to the LP or LLC interest. Further, an assignee of an LP interest will be treated as a substitute LP for Federal income tax purposes. While the ruling is only two paragraphs in length, creditor-protection advocates never discuss the reason for the holding, which, on close examination, does not support broad application to all assignments or charging orders.

In the ruling, an LP agreement permitted an LP interest holder to assign (without the general partner's consent) the right to share in profits and losses and to receive all distributions to which the holder was entitled. An LP interest holder made such an assignment and also agreed to exercise any residual powers in the assignee's favor. In general, residual LP rights can include the right to (1) vote on matters (such as a dissolution or merger of the partnership, a change in the partnership's business or removal of a general partner), (2) access to partnership records, (3) withdraw under specific circumstances and (4) sue a general partner for a breach of fiduciary duty. The ruling concluded that because the assignee had acquired "substantially all of the dominion and control over" the LP interest, the assignee would be treated as a substitute LP for Federal income tax purposes. The ruling offered no detailed explanation for the holding, which should be a warning for those who seek to broadly apply it to other fact patterns.

Before issuing the ruling, the IRS's Individual Tax Division asked the Chief Counsel's office to concur. General Counsel Memorandum (GCM) 36960, dated less than two weeks before issuance of the ruling, made a significantly more detailed assessment of the issue, agreeing with the ruling's conclusion. Although lacking the authoritative weight of the published ruling, the GCM is instructive as to how the "dominion and control" standard of the ruling may apply to other assignment fact patterns.

The GCM relied heavily on the opinions in Evans, 54 TC 40 (1970), aff'd, 447 F2d 547 (7th Cir. 1971). Evans involved a sale of a partnership interest to a seller's corporation, which was consummated without the other partner's consent. The Tax Court and Seventh Circuit found that the corporation, as assignee, would be the partner for Federal income tax purposes. The Service issued a nonacquiescence to Evans but reconsidered in the GCM, stating that in its interpretation of Evans, the "decisive factor" was dominion and control over the assigned interest.

Although the taxpayer in Evans assigned the interest without the other partner's consent, the assignor was an officer and director of the assignee corporation and would have to exercise residual partnership powers on the corporation's behalf in his capacity as a fiduciary of the corporation. According to the GCM, if the assignment were made to a "stranger" (to whom no fiduciary duty was owed), the assignor should continue to be taxed on partnership income if the assignor held residual powers granted under state partnership law that were greater than the assignee's. The GCM concluded that if an assignment were made without any provision for exercise of residual rights in the assignee's favor, the assignor would continue to have dominion and control over the partnership interest. This conclusion may best explain the holding in Rev. Rul. 77-137, in which the assignor agreed to exercise all residual powers on the assignee's behalf, so that all dominion and control of the LP interest had been transferred.

The ruling's conclusion may not apply to an assignment or to a charging order in which there is no effective release of residual powers. The IRS followed its dominion-and-control standard in Letter Ruling 8350033, in which a partnership agreement alone provided that all rights and powers of an LP would be transferred to the assignee, so that no separate agreement was necessary to transfer dominion and control. The charging order creditor-protection strategy is always presented as a hostile situation in which the potential for receiving a Schedule K-1 is intended to dissuade a creditor. The assignments presented in Rev. Rul. 77-137 and Letter Ruling 8350033 were much friendlier scenarios.

It is not clear whether courts will follow the same dominion-and-control approach adopted by the IRS. In Roggin, TC Memo 1985-307, a partner assigned his interest to his corporation. Following the Service's assessment of Evans (as found in GCM 36960), the IRS would have been expected to respect the assignee corporation as a partner because of the fiduciary duty that the assignor owed to the assignee corporation. Instead, it sought to tax the assignor on all partnership income under assignment-of-income principles or proper reflection of income under Sec. 482. The Tax Court noted this seeming inconsistency in the Service's approach in a footnote and held for the taxpayer. The Tax Court's approach was not entirely clear, although the implied consent of the other partners supported the substitution of the corporation as a partner. Similar to Rev. Rul. 77-137, Roggin was not the hostile scenario suggested in the literature discussing the tax effects of a charging order on a creditor.

Clearly, an assignee would become a substitute partner if an assignment is both friendly and well planned. If a partnership agreement provides that any residual powers will be exercisable on the assignee's belief, or the friendly assignment is accompanied by a written agreement for the assignor to exercise any residual powers in the assignee's favor, both the IRS and the Tax Court should treat the assignee as a substitute partner. However, if the assignment is a hostile one, or is a court-ordered charging order granting the right to distributions but no residual powers, it is not clear that the assignee or judgment creditor will be respected as a partner, at least under the standard established in Rev. Rul. 77-137.

Conclusion

The tax adviser whose client was advised of the punitive tax treatment visited on a creditor who obtains a charging order against an LP interest would be well advised to evaluate the standards of Rev. Rul. 77-137 and related authorities against the specific powers granted under a charging order (which are strictly construed), before concluding that the creditor will be a substitute partner for tax purposes. Such may be the answer, but the legal analysis is far more complicated than is typically recognized.

FROM JAMES R. HAMILL, CPA, PH.D., KPMG PROFESSOR OF ACCOUNTING, UNIVERSITY OF NEW MEXICO, ALBUQUERQUE, NM (NOT AFFILIATED WITH BAKER TILLY INTERNATIONAL)